10 rules to earn most from your investments

Rediff 3/2/09 (Excerpts from the book Trading Rules from the Masters: Money-Making Lessons from 50 of the World’s Top Experts published by Vision Books. This piece is by Ben Warwick, Chief Investment Officer at Sovereign Wealth Management.)

Alpha is the measure of investment return above a market index. Considering the small number of mutual funds that produce market-beating returns, the task may seem nearly impossible.

Even so, there remains an elite group of investment professionals who manage to produce market-beating returns, year after year. Find out what their edge is and how you can use it to achieve superior investment returns.

Embrace diversification

The real trick to beating the market is not portfolio concentration – it’s holding a little bit of everything, and overweighing the sectors that have the best chance to outperform. Although famous investors like John Maynard Keynes and Warren Buffett have produced fabulous returns through a small number of large positions, they are the exception rather than the rule.

Index the hard stuff

Market sectors vary in how quickly they respond to information. Large cap stocks, for example, are followed by so many analysts and reflect company fundamentals so quickly that it is nearly impossible to add value through active strategies. I recommend indexing such sectors.

Use active strategies in inefficient market sectors

Although some parts of the market are tenaciously efficient, there are certain sectors – small cap stocks and high yield bonds are two examples – where active management can really pay off. For these sectors, use active managers that have a unique and scalable methodology to produce alpha (i.e. return over a market index).

Use the credit spread to ’tilt’ your portfolio toward growth or value stocks

The stock market is not one coherent group of equities. Different types of stocks react to changes in the economic environment in unique ways. Small cap stocks, for example, do better during recessions or when equities are in a downtrend.

Large cap stocks tend to lead the market higher during the good times. Look at the credit spread – the difference between the yield of government and corporate bonds – to determine whether the economy is expanding or contracting (a growing economy is associated with a narrowing of the spread), and tilt your portfolio to the market sector that is poised to benefit the most.

Consider the yield curve when buying fixed-income investments

An ‘inverted yield curve’ – a scenario when Treasury bills yield more than ten-year government notes (gilts) – boasts a 30-year record of flawlessly predicting recessions. If this occurs, the long end of the yield curve will generate the best performance over the intermediate term. In a normal yield curve scenario, the middle part of the curve will usually deliver the best risk-adjusted return.

Utilise momentum strategies only during periods of economic growth

Momentum traders buy stocks that have increased the most in the belief that they will continue to do so in the future. Although there is a plethora of evidence showing that market sectors exhibit trend-following behaviour during periods of expansion, a weak economic environment usually prevents such momentum players from generating a market-beating return.

Consider alternative investments

With the increased integration of the world economy, stock and bond markets have become globally linked. Prudent investors should consider skill-based investments in the futures markets and through market- neutral hedge funds (unregulated investment pools that generate profits through an arbitrage approach) to add value diversification to their portfolios. The steady returns of these investments go a long way in producing market-beating returns.

Think about taxes

Taxes are frequently the largest expense that investors face, surpassing both commissions and investment management fees. Tax gains are largely the result of the efforts of money managers who attempt to add value to the investment process by buying and selling of securities. Taxes can be minimised by indexing the hard stuff and by keeping all actively managed funds in a tax-deferred account.

Don’t pick an investment manager based solely on past performance

When considering a mutual fund investment, there are more important things to look at than the manager’s past return stream. Consider transaction costs, fees, and the fund’s research budget. These three criteria are much better indicators of what may occur in the future.

Rebalance your portfolio on a regular basis

Over the long-term, markets exhibit mean-reverting behaviour; in other words, winners become losers and losers become winners. For this reason, it is important to periodically rebalance your portfolio by taking money away from those investments that have performed well in the past few months and reallocating it to those that have suffered losses. By doing this, you can both increase your returns and reduce your dependence on a few bets that have appreciated significantly.